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Steve Ouma Oyugi Macro Economics Kimathi University College of Technology

2nd Year 2nd Semester

Macroeconomics 1. Theory of income, output and or panic buying.
employment. The elements herein 3. Other causes of inflation could be
The Relationship between Macro and are: cost push inflation.
Microeconomics • Theory of consumption 4. Economic growth – this is
function sustained growth in national
Microeconomics deals with the behavior of • Theory of investment function incomes. Keynes concentrated
individuals, consumers, factor owners, firms, • Theory of business cycle mainly on short-term growth but we
individual industries and individual markets. 2. Theory of prices whose elements know that economic growth is a
function of levels of investment. A
Macroeconomics on the other hand deals certain level of economic growth is
• Inflation
with a holistic approach of the economy by needed to sustain a steady growth as
• Deflation explained by growth models.
dealing with various aggregates, which
• Reflation
include: 5. Stagflation – this is a special form
• Stagflation of inflation resulting from the supply
1. Total employees 3. Theory of Economic Growth side constraints. The Keynesian
2. National income 4. Macro theory of Economic Growth economy focuses mainly on demand
3. General price levels side constraints, but modern
4. Inflation e.t.c. These elements are explained further as: macroeconomists reveal supply side
constraints, which can come from
Macroeconomics tries to explain what Employments and unemployment supply shocks.
determines the level of total National 6. Balance of payments (BOP) and
Economic activity and what causes There are several causes of unemployment [Exchange rates] - this is an analysis
economic growth. and involuntary unemployment. They of transactions of the residents of a
include: country with the rest of the world
The classical economists had the basic within a certain period. It takes
principle that the economy had self 1. National income/Gross National account of imports, exports and
-adjusting mechanisms to remain at full Product – this is the total value of all capital exchange leading to either
employment. This was based on the JB Say final goods and services produced in supply or deficits. Exchange rate is
laws of the market, which says that a country within a year. It the rate at which a country’s
demand creates its own supply. determines per capita income, also currency exchanges with another’s
determined by the level of physical currency.
British Economist JM Keynes (1883 – capital, human capital and
1946) showed that an existence of great technology. A microeconomic approach has limitations
and involuntary unemployment during the 2. General price level and inflation to the extent that there it creates self
depression of 1930 created the grounds on – The classical economists argued confusing paradoxes. A firm will make more
which macroeconomics is founded. that inflation and prices was profits by cutting wages and thus
determined by the amount of money maximizing profits. This, when looked at
Central issues in Macroeconomics in circulation. Keynes introduced from a macroeconomics view reduces
Macroeconomics deals with the following the demand pool theory of aggregate demand.
studies, which makes up its scope: inflation caused by excessive
demand as can happen during boom
Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
Savings 3. An aggregative tendency does not government (G).
An individual or a firms saving is influence all sectors of the economy 4. Net exports (X-M).
encouraged but at a micro economic level in the same way thus precaution has Y=C+I+G+(X-M)
may lead to a fall in the national income. to be taken incase it happens. E.g. 5. Net factor income which the
Macroeconomic approach helps formulate some industries may benefit more difference between net factor
government macro policies and thus than others with an increase in the incomes such as wages.
accelerating economic growth. general price level.
4. Macro-analysis is fruitful when Gross Domestic Product
Extra work aggregate variables are accurately This is the monetary value of goods and
Advantages of Macroeconomics measured. However even with an services produced by the normal
1. Formulation and execution of advanced statistical procedure, residents and non-residents of a country
economic policies by the desirable accuracy in the less the net factor incomes earned
government. measurement of macro-economic abroad.
2. Indispensable for the study of variables is not possible e.g. it is not
macroeconomics, which is necessary easy to accurately measure the GDP = GNP – NFI
for studying the vast fields of factor national income of an economy.
generalizations. Note that net factor income is different
3. Indispensable for the study of National Income and National Income from net exports and imports and thus
microeconomics. No laws of Accounting don’t form part of GNP or GDP.
microeconomics can be formulated
unless pre-study of the aggregates National income is the total market value Net National Product
bearing on it have been made. of all goods and services produced within This is the market value of all final goods
4. Indispensable for the study of the economy within a year. National income and services after providing for
aggregate values. There is a clear is a monetary measure and takes account of depreciation.
difference between individual and final goods without intermediaries.
group behavior and as such what is NNP = GNP – Depreciation
applicable to a firm may not be true National Income = National Expenditure =
for the whole economy. National Product National Income and Factor Cost;
5. Indispensable for guiding these take into account indirect taxes
governments. Gross National Product and subsidies. The difference between
This refers to the value of goods and total and direct taxes and subsidies is
Disadvantage of Macroeconomics services produced by the residents of a referred to as Net Indirect taxes.
1. The study of individual units in some country, whether locals or foreigners. This
cases is very important and as such constitutes: NI (factor cost) = Net National Product –
microeconomics is implemented Indirect taxes + subsidies.
instead. 1. Value of goods and services
2. Macroeconomics is applicable in produced and consumed by the Circular Flow of Income
studying homogeneous aggregate consumers (C).
variables only, and as such cant be 2. New capital goods plus inventories, This is a very simple model showing the
applied in the context of not sold during a year (I). working of the economy, depicting
heterogeneous variables. 3. Goods and services from the movements of resources between the

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
producers and consumers. deficit. If the government expenditure
It shows how income moves from one sector Savings = Investments exceeds the tax collected, then there would
of the economy to another in a series of be a budget deficit. To finance this deficit,
monetary movements. Three Sector Model of Circular Flow of the government borrows from the financial
Income (Open Model) market and this reduces private investment
Two-Sector Model of Circular Flow of hence government borrowing crowds out
Income (Closed Economy) In this model, the government is included. private investment.
The intervention of the government
In a simple microeconomic model, we involves: National Income Identity in a 4 Sector
assume that there is no government i) Taxation Model
intervention and no foreign trade. In this ii) Government Expenditure
case, the value of the Output Y Produced = iii) Government Borrowing In a 4-sector model, we introduce trade but
the value of Output sold. we assume that it is only the business firms
that interact with the foreign countries.
4 sector Models

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1. Y = C + I Identities
C-Consumption Expenditure The National Income Identity = Total
I - Investments expenditure
What happens to produced 1. Y = C + I + G NI Identity
income which is not consumed?
1. Y = C + I + G + (X - M)
It is used to increase the inventories, Total income consumed, saved and taxed. Where (X - M) = Xn
which is treated as actual 2. Y = C + S + T 2. Y = C + I + G + Xn
investments or savings.
Since; Y=C+S+T
2. Y = C + S
Putting equations 1 and 2 together Y= E (Expenditure) Thus
3. I + G + Xn = S + T
C+I=C+S 3. C + I + G = C + S + T
I=S 4. G - T (Deficit/Surplus) = S - I The meaning of equation 3 is that the total
NB: - In a simple two sector model
private investments + government
where there is no government Equation 4 explains the government budget expenditure + net export = savings + Net
intervention or foreign trade;
Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
Revenue land, interest on capital, wages and of Welfare
salaries and profits from • The GDP should factor in the
Measuring the National Income entrepreneurs. number of working hours and the
Ways; conditions therein. GDP ignores
1. Value added method 3. Expenditure method non-monetary services.
This divides the economy into Involves adding up all the • GDP should measure the levels of
sectors such as fishing, mining, expenditures made on goods and environmental degradation and
agriculture, transport, industry, services within 1 year. This the pollution and should factor in
manufacturing e.t.c. We then expenditure is on the consumer the cost of rehabilitation and
calculate the net value added by goods and services by individuals reclamation.
each sector at factor cost and market and households denoted by (C), the • GDP does not take into
price. In order to obtain the net government expenditure denoted as consideration the distribution of
value, we subtract the cost of (G), expenditure on the capital goods national incomes and its usage
intermediaries (raw materials used to and inventories denoted as (I) and e.g. expenditure on war and
produce the end product, capital Net Export Expenditure denoted at (X national security budget.
depreciation) but add the net factor - M) where (X - M) is Xn.
income from abroad. The Aggregation of the Economy
NB: - NI or Net National Product = GDP = C + I + G + Xn. • Product Market
NDP (fc) + NFI. Where fc means at • Labour Market
factor cost. Difficulties in measuring
• Money Market
Significance of the value added National Income
• Bonds and Equities Market
method • Treatment of non-monetary
• The method reveals the transactions e.g. housewives
The economy is divided into the above four
performance of the sector. services and household
Precautions to take when using consumption.
the value added method • Treatment of government Product Market
• The value of self occupied houses activities like defense, social
should be included. services like free education and The equilibrium in the product market is
• 2nd hand goods are excluded achieved when output = demand.
• Activities of foreign firms and
• Production for self consumption profit repatriation. NB: - Income Y = C + I + G + (X - M)
should be included
from foreign firms is introduced
• Services from housewives is and treated as National Income
normally omitted due to C in our analysis
yet we know that it ends up back
complications that arise in in their countries.
computation. Keynesian Model of National Income
• Lack of accurate record keeping Determination
particularly by the households.
2. Income method
• Lack of specialization by Income and Expenditure Approach
The NI is obtained by summing up
household. The Keynesian is a short-term approach,
the incomes of all individuals of a
country. This constitutes rent from which assumes that the price level in the
Limitations of GDP as a Measure
Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
economy remains unchanged.
Keynes also assumes that the stock of Keynes assumes that investment is
capital, techniques of productions and labor autonomous and does not change with the
efficiency remain unchanged. changing levels of income.
In his model, income is a function of the
level of employment since labor is the only
variable factor. The level of employment is QuickTimeª and a
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Consumption Demand QuickTimeª and a

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This depends on the marginal propensity to
consume and the level of National income.

The classical economists assumed that the

equilibrium level of National Income is
established at full employment and the
economy always tends towards full
Take note that C + I is parallel to C = a + employment through self adjusting
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constant and does not depend on change in Assuming a state of employment,
income. corresponding to OYF level of National
Income but according to Keynes, equilibrium
Aggregate Supply is established at level E, which corresponds
The short run level of National Income to OY level of National Income. This causes
depends on Aggregate supply and demand. a level of unemployment.
Aggregate supply is composed of consumer
goods and services as well as capital goods. For full employment to be achieved,
OZ is the income line Keynes assumed unchanging capital stock investment demand must equal RH, but at E
and level of technology, with labor being the it is only equal to EQ, therefore full
The point beyond E represents savings of only variable factor. employment is not always guaranteed. Full
the community, given by the identity Y = C employment is not always guaranteed
+ S. because there are savers and they not
necessarily invest their money. Investment
Investment Demand in most instances is undertaken by
This is a component of aggregate demand Entrepreneurs.
determined by: Keynes Criticism of Classical
1. Marginal efficiency of capital Economists There may also be several other reasons for
(Expected Rates of Profits) saving such as to provide for education and
2. Rate of interest contingencies, holidays and even at old age

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
and retirement. Therefore savings may not and means of production. Keynes proposed
be equal to investments, this results to a such measures as increased government
level of unemployment. Savings Investment Approach expenditure as a remedy for Europe.
If this is applied in developing countries it is
The level of investment depends upon the Y=C+S going to be inflationary. Dr. R. V. Rao
marginal efficiency of Capital, which is the C=Y–S ascertains that the Keynesian multiplier is
main motivation for investment. i.e. if the Y=Y–S+I inapplicable in underdeveloped/developing
expected rates of profits are not favorable, Thus; economies since it will lead in a rise in
then people are not able to invest. S=I prices. This is because the supply curve of
But Y = C + I; thus I = Y – C output is relatively inelastic, therefore rising
Keynes Analysis of a 2 Sector Model Yet C = a + bY demand would lead to inflation.
(Keynesian Multipliers) Therefore: - However, to obtain Y = (I + Application of Consumption Function
We assume that there isn’t government C=Y–S then since S=I from iii Aggregate demand and supply cannot fully
taxation and expenditure and we are a + bY = Y – SI=Y – a - bY explain full employment and for
dealing with a closed economy. Thus Y=I + a + bY employment to exist savings must equal
S = Y – a – bY investments failure to which we experience
National Income Y=C+I = -a + Y – bY involuntary unemployment.
Consumption C = a + bY = -a + Y(1 – b) Marginal propensity to consume explains
Investment I = Ia (Investment is the consumption changes. Consumption
autonomous) 1 – b is the marginal propensity to save. If changes at a lower rate than increase in
Thus; the level of savings is very high then the income.
Y = (a + bY) + Ia level of multiplier increases too. In order to maintain a certain level of
Y = a + bY + Ia income and employment the gap between
Y – bY = a + Ia Relevance of Keynesian Analysis in income and consumption should be
Y(1 – b) = a + Ia Respect to Developing Countries matched by investment to prevent
Y = (a + Ia)/(1-b) unemployment.
Thus; Keynes put forward a theory of income and It is important in understanding the
Y = [1/(1-b)]a+Ia employment, which explains the multiplier since the size of the multiplier
determination of income and employment depends on the marginal propensity to
Nb: - An increase in b leads to an increase in through the aggregate demand and supply. consume.
Y ***Keynes, at a time of economic depression Entrepreneurs base their investments on
(1930’s) in Europe, where the level of the marginal efficiency of capital, which is
Equation iii shows the equilibrium level of aggregate demand was the main cause of determined by current levels of
occurring where Aggregate Demand is equal unemployment consumption.
to aggregate supply. Consumption function explains business
The level of equilibrium Y can be obtained in developing economies, poverty and cycles since marginal propensity takes the
by multiplying the autonomous investment unemployment result from lack of capital, form 0<mpc<1. Marginal propensity varies
by the multiplier. The higher the marginal relative to labor availability. less than the change in income.
propensity to consume the higher the level Thus in developing nations, there is supply
of income. side constraint resulting from lack of capital Leakages in a multiplier

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
An investments results to an increase in This does not change with income, and this This is the rate of profits expected from an
income by the value of the multiplier. kind of expenditure would include extra unit of capital asset. This is
However, income doesn’t increase government investment in roads. determined by(depends on) the supply price
indefinitely since the marginal propensity to or the cost of capital and also depends on
consume is less than one due to the Induced Investment expected yields of investments.
following leakages; This is investment that is affected by
Savings changes in the level of income.
Debt payment C is the supply price of the cost of capital
Precautionary and speculatory motives of R is the annual expected yields of
holding investments
cash balances r is the expected rates of return of profits.
Importation – increase income in foreign
countries Investment Demand
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The theory of the multiplier is one of the
greatest contributions of J. M. Keynes. It
explains the effect of investments in an
economy and can be used to explain the
effect of investments in an economy and
can be sued to explain trade cycles of boom
and depression. It normally applied by the
government in its physical policy to move
the economy from depression or to check
inflation and unemployment through It depends upon the marginal efficiency of Equilibrium level of investment is attained
expansionary and contractionary fiscal capital, or the expected rates of profits. It is where the marginal efficiency of capital is
policies. also affected by the rates of interest. For an equal to the current rates of interest.
investment choice to be made, it must be The marginal efficiency thus represents
Investment expected to fetch higher returns than the investments.
(This is an increase in the stock of capital) current market rate of interest. Marginal Economic depression is a signal of expected
Investment is new expenditure incurred on efficiency of capital in reality is a higher marginal efficiency of capital hence low
addition of physical stock of capital e.g. inducement for investment since the market investment demand.
machinery, plant, equipment, tools and rate of interest is ‘sticky’.
inventory. Interest on the other hand is determined by Marginal efficiency of capital (shift
This should be differentiated from financial liquidity preference and money supply. The outwards)
investment, which involves trading in greater the liquidity preference the higher • Increase in demand for products
shares, stocks and bonds, which is simply the interest rate and the greater the money leads to change in level of
the transfer of ownership. supply the lower is the interest rate. investments
• Change in technology and efficiency
Autonomous Investment Marginal efficiency of capital
• User cost of capital (this determines

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology
Steve Ouma Oyugi Macro Economics Kimathi University College of Technology
2nd Year 2nd Semester
the rate of return on capital) more due to change in income from Yt-1 to
• Credit availability Yt.
• Government fiscal policy
(government borrowing crowds out This means that investment is also a
private investment) function of a change in income.
• Government expenditure on
infrastructure, communication, roads
and security affects the levels of

Accelerator Principle on Investments

Post Keynesian economists argue that

investments is also a function of income
since an increase in income increases
consumption. Increased consumption
causes increased investments by a multiple
amount. Investment is therefore induced by
changes in income or consumption.
To produce a certain amount of output one
requires a certain amount of capital, and
this amount at time t, gives a certain
amount of income at time t.
Kt is the stock of capital at time t, and Yt is
the level of output at time t, and V is the
capital output of ratio.

An increase in income from Y(t – 1 )

(previous period) to Yt increases the stock of
capital from K(t-1) to Kt. Money
The change in the stock of capital between
t-1 and t would be given by [Kt – K(t-1)]
(Investment) = VYt – VY (t-1)

I = V(Yt – Y(t-1)

Investment will increase three times more

due to change in income, thus V represents
the value of the accelerator. If V = 3, then it
means that investment changes 3 times

Steve Ouma Oyugi Macro Economics 7th July 2010 Kimathi University College of Technology